At 2%, a little inflation goes a long way

May 25, 2018

There’s been a good deal of talk this year about rising inflation, and for good reason: With unemployment at historically low levels and the effects of December’s corporate and individual tax cuts beginning to work their way through the system, there are multiple factors pushing inflation expectations higher.

To that end, core personal consumption expenditures (PCE), the U.S. Federal Reserve’s (Fed’s) preferred inflation gauge, ticked up to 2% in March—its highest reading in more than a year.1 But what exactly does this suggest? Is rising inflation a threat to the economy? The answer depends, like so many aspects of the economy, on the trends behind the data.

Too much—or too little—inflation can derail an economy

Inflation is typically measured by looking at the average national costs associated with a broad basket of goods and services; “core” inflation, the most frequently cited variety, excludes food and energy, the prices of which tend to be volatile. A high level of inflation—such as the nearly double-digit inflation the United States battled in the late 1970s and early 1980s—is inherently bad for economies. Because prices are rapidly increasing, the value of consumers’ savings is eroded. Consumers often decrease their levels of saving and investment, but spending also becomes a problem, with the prices of goods escalating much faster than incomes. Companies, on the other hand, can’t afford to hire new workers, and the future values of stocks and bonds in general become much more difficult to gauge. It’s not a pretty picture.

On the other hand, deflation can be just as problematic—and in many ways is more of a challenge to curb. Deflation occurs when prices drop significantly over time in a sustained fashion. Rather than eroding consumers’ purchasing power, deflation acts in reverse: Every dollar of savings or income a consumer has or earns is worth more the longer they wait to spend it. The same, of course, is also true for businesses considering capital investments. And deflation, unlike inflation, can’t be cured by raising interest rates to pump the brakes on an overheating economy. It often requires more creative monetary policy from central banks and from federal governments to encourage spending and investment.

The Fed’s Goldilocks inflation rate

For these reasons, it’s generally agreed that a small and stable rate of inflation is the best state for an economy. In fact, the Fed puts a number on it: a 2% annual growth rate in core PCE, which is essentially where we stand today.2 But what does that actually mean?

The categories of goods and services that are measured when constructing PCE are diverse and include housing, apparel, medical care, and transportation, to name a few. The 2% figure means that that basket of goods and services was 2% more expensive in March 2018 than it was one year ago.

What PCE doesn’t measure directly—but the U.S. Bureau of Economic Analysis, which publishes the survey, does track—is income. Generally speaking, when inflation is materializing in the form of higher wages—which is something economists have been expecting for some time given the extremely low unemployment levels—that’s good news for the economy. Wage growth in recent months has been somewhat modest, though improving, climbing at a rate of nearly 4% year over year.1 This higher growth rate in incomes should be a welcome development, even if accompanied by a slightly higher rate of inflation overall.

Another factor worth watching is commodity prices. President Trump has made repeated calls for tariffs on certain imports and, while the odds of a trade war with China have fallen significantly in recent weeks, more saber rattling on the trade front seems all but inevitable. While we’re not currently experiencing it, rising inflation due to artificially inflated raw material costs would be detrimental to the economy, particularly to the manufacturing sector.

The Fed is unlikely to change course on interest rates

All in all, unless there are dramatic changes to core PCE readings or incomes, there’s no good reason for the Fed to begin increasing interest rates more aggressively than it has been: The consensus for 2018 remains three, possibly four, quarter-point moves. The U.S. economy, which hasn’t experienced inflation north of 2% since 2012, is in no immediate danger of overheating.1 All things considered, today’s rate of inflation is a healthy backdrop for sustained economic growth and for the continued normalization of monetary policy.

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